Question

Suppose there are two potential projects for investment. Project 1 has a certain payoff of $50 in one year, while project 2 has a 50% chance of generating $100 in one year, and another 50% chance of generating $0 in one year. Suppose the company has an outstanding debt = $50.

(1)Which project will shareholders prefer? Justify your answer.

(2)Which project will debt holders prefer? Justify your answer.

(3)Which project will the financial manager prefer? Justify your answer.

Answer 1

Expected Payoff = $ 50 * 100%

= $ 50

Project 2:

Year	Prob	Payoff	Expected Payoff
1	0.5	$     100.00	$        50.00
2	0.5	$              -	$              -
Expected Payoff	50

Generally Debt holders will receive Int on debt only. Any additional values will not flow to debt holders.

Part1:

Equity holders are ready to take risk and hence they will select Project 2 which is having expedted Payoff of $ 50. However It can gp upto $ 100.

Part 2:

Generally Debt holders will receive Int on debt only. Any additional values will not flow to debt holders.Hence they will choose Project1.

Part 3:

Project 1 is haing expected Payoff of $50 with 0% risk

Project 2 Having expected Payoff of $ 50 with risk.

Hence I will select Project 1.

Pls do rate, if the answer is correct and comment, if any further assistance is required